I want to talk about structural complexity and innovation. Complexity has gotten a really bad name resulting from the collapse of many highly-structured transactions in the firestorm following the recession and Lehman’s collapse. That’s certainly an understandable reaction. Enormous losses were incurred on transactions barely understood by investors and perhaps by sponsors as well. And while I won’t go so far as to trot out the old saw, “Guns don’t kill people, people do,” the resulting hostility to complexity has conflated good complexity resulting from purpose-driven transaction structures and opaque, dysfunctional documentation and disclosure. The hostility toward complexity limits both risk mitigation and innovation, just at the time both are critically important to repair CRE debt capital markets.
Financial engineering is, in large measure, about risk transfer and the need to meet the needs of investors. It is a process of identifying risk, mitigating risk, and fine-tuning structure to do very specific things. Structures which can reduce deal risk and deliver solutions to very specific investor requirements will grow liquidity. With the growth of liquidity comes transactional efficiency and that way lies market growth.
I’ve been thinking a lot about complexity recently as we spend time on both broken CDOs from before the apocalypse and recent efforts around utilizing securitization in new ways; including using securitization to finance liquidating vehicles and as a warehouse vehicle for non-stabilized loans. On the front lines of investor relations, there is clearly a push and tug going on between the perceived attractions of simplicity, “Keep it simple, stupid,” and the manifest benefits of engineering around risks and delivering targeted results, e.g., structural complexity.
The simplicity argument is really not about complexity per se, but about comprehensibility. Do I have the information and can I understand it? Transparency, we got. Investors can read a numbing abundance of disclosure, get access reams of data, and review the underlying legal documents. Comprehensibility means more than transparency, it denotes an investor’s ability, in a reasonable time frame and with reasonable resources, to understand the structure; understand the risks, and understand, with some level of granularity, how the structure works and what it will do.
We need to work harder to meet this standard. I am reminded of a conversation I had with a member of the Financial Accounting Standards Board when arguing about sale accounting several years ago. I was, I am sure, asserting annoyingly that the rules did not help a reader of the financial statements understand the financial condition of the reporting entity. My confrere retorted angrily that accounting rules were not about making the financial condition of a reporting entity easily understood, but about the internal integrity of the rule system. That moment has stuck with me. That was the response of someone so inured to the dissonance between the inner language of the isolated priesthood of accountancy and the broader world of those who used financial statements that he was insensitive to accounting’s basic purpose in the greater world: make the financial condition of companies clear and understandable!
It is, in many ways, easier to construct documents and disclosure that work and are exhaustively comprehensive than paper that is clear and intuitively understandable; that has explanatory power. Structured finance documentation and disclosure can be turgidly unnarrative, non-intuitive and opaque. No one is suggesting that opacity is the goal, but perhaps there has been too little premium placed on making disclosure and transactional documents narratively understandable and compelling. We numbingly repeat disclosure again and again. Bowing down to the Blackline God, we torque language and ignore compelling cleanups to limit blackline changes. We embed definition inside definition like Russian dolls, and spray cross-references across documents to the point of rendering the reader numbingly insensible. It all works, but is simply very hard to follow and comprehend.
There’s no reason disclosure can’t be crisper and shorter and more to the point, and there’s no reason documents can’t be more accessible to a reasonably intelligent financial market player. It is incomprehensibility, not complexity, that suppresses demand for our bonds. Purpose driven structural complexity which mitigates risk and achieves targeted business goals is good.
So let’s not let investors and others blithely conflate bad with complex. Complexity is the inevitable consequence of effective risk mitigation and the need to achieve specific investor requirements. If risk can be mitigated and investor needs met, liquidity will be enhanced. So here’s a trade: let’s work on making our documents narratively understandable and our disclosure crisper (and please, dear Lord, shorter). Let’s embrace structural complexity when it achieves business goals. Go on, it won’t hurt to do some long overdue surgery on our documents, and it will make it easier to sell bonds.
By: Rick Jones